The Swiss National Bank plays the FX options market

By Felix Salmon

September 8, 2011

Eric Burroughs has a fabulous scoop today: the Swiss National Bank isn't just buying euros at a rate of 1.20 Swiss francs to the euro. "
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Eric Burroughs has a fabulous scoop today: the Swiss National Bank isn’t just buying euros at a rate of 1.20 Swiss francs to the euro. (If that was all it was doing, in fact, it would yet to have spent any money at all: the exchange rate hasn’t hit that level since the announcement.) Instead, or as well, the SNB is intervening aggressively in the FX options market. And not the plain-vanilla exchange-traded options market, either: the SNB seems to have been a huge seller of forward volatility agreements — essentially taking a massive short position in the volatility of the euro/Swissie exchange rate.

But a picture, here, tells a thousand words. If you recall my post from immediately after the SNB announcement, you’ll remember these charts:

The left-hand chart is the euro/Swissie volatility surface on August 22; the right-hand chart is the same surface on September 6, after the announcement. It’s even more skewed: people are still bearish on the euro and bullish on the Swiss franc, and expecting lots of volatility ahead.

Now check out what the same surface looks like today:

Now that’s what I call a dramatic one-day move. And remember, this move came after the market reacted to the SNB announcement — no one was expecting this, not even after the SNB said what it was going to do.

This is a bold move by the SNB, even if it might prove expensive should things not go according to plan:

Selling volatility also means that the SNB has forced the euro/Swiss franc options market to turn suddenly long gamma, so that the hedging of option dealers would help dampen the daily moves in the currency pair. The opposite happens when the options market is short gamma, exacerbating sharp market swings.

“Long gamma”, here, means that if you hold an option, it will make a lot of money even on a relatively small move in the currency pair. By contrast, before this intervention, implied volatilities were so high that the Swiss franc needed to move as much as 4% in one week in order to make options trades profitable. (Which, of course, it did.)

Essentially, the SNB is trying to calm down the options market, and thereby calm down volatility in the swap price: the two feed off each other very closely. But the problem with doing things like buying double-no-touch options is that it gives the market every incentive to try and make the exchange rate hit the strike price — it’s almost an “I dare you”. So far, the market hasn’t really tested the SNB’s steadfastness on this issue. But the two are sure to butt heads at some point. And the SNB here, is maximizing the amount it has to lose if the market wins.